In Basic Engineering, Inc. v. Commissioner, the Tax Court has held a corporation is not eligible to use the completed contract method of accounting for two contracts because it did not prove that it reasonably believed the contracts would be completed within two years from the commencement dates.

Facts

Basic Engineering, Inc. engineers and delivers crude oil processing and refining systems to customers in the petrochemical industry. Thomas Balke owned 51% of Basic Engineering and James Smith owned 49%. They also owned Basic Equipment, Inc, with Balke as president of both companies.

Basic Engineering entered into two contracts — one with Petromaxx Energy Group GmbH (Petromaxx) and one with Amber Energy S.A. (Amber). Basic Engineering used the completed contract method of accounting for its long-term contracts.

Petromaxx contract

Basic Engineering and Petromaxx entered into a sale and purchase agreement on October 28, 2006. Under the contract, Petromaxx agreed to purchase crude oil processing units from Basic Engineering and pay Basic Engineering $90.5 million for completion of the work. Basic Engineering agreed to refurbish oil processing units and provide Petromaxx with engineering specifications for installing the refurbished units and constructing an operating refinery.

Basic Engineering and Petromaxx amended their contract on October 6, 2007, because Petromaxx wanted to increase the capacity of the refinery. Under the amended contract, Petromaxx agreed to pay Basic Engineering an additional $31,750,000 for the refurbishment of additional equipment that would give Petromaxx the ability to meet its capacity requirements. The total contract price was approximately $122.3 million. At the time the amendment was signed, Petromaxx had made payments to Basic Engineering of $72.4 million.

The contract did not contain a project schedule or project completion date, but required Basic Engineering to deliver the last refurbished unit by April 30, 2007. If Basic Engineering failed to deliver the last refurbished unit by April 30, 2007, and then did not make delivery by September 12, 2007, the contract provided that Basic Engineering would be in default of the contract terms, but no penalties would apply. Another section of the contract, however, requires Basic Engineering to make delivery within 12 months of signing the contract on October 28, 2006.

The Petromaxx refinery was not completed and Petromaxx lost its financing in the course of the project.

Amber contract

Basic Engineering and Amber entered into a sale and purchase agreement on July 17, 2008. Under the contract, Basic Engineering agreed to procure oil processing units from third-party vendors, refurbish the units and deliver the units to a designated location. Basic Engineering also had to acquire a fluid catalytic cracker unit for use in the project. In consideration for the work, Amber agreed to pay Basic Engineering $100 million.

The contract did not include a project schedule or project completion date, but the contract required Basic Engineering to deliver the last unit no later than November 15, 2010. The contract allowed for bonus payments if the units were delivered before November 15, 2010, and penalties if Basic Engineering delivered the units after that date.

On January 18, 2010, Basic Engineering and Amber cancelled the contract and released each other from all responsibilities and liabilities under the contract.

Basic Engineering's income tax return

Basic Engineering used the completed contract method of accounting from 2005 to 2010 for the Petromaxx and Amber contracts. Because the contracts were not completed, Basic Engineering did not report income or expenses associated with those contracts for the years at issue (2009 and 2010).

The IRS determined that Basic Engineering could not use the completed contract method of accounting and issued a notice of deficiency. The IRS concluded that Basic Engineering should have reported the Petromaxx contract as a manufacturing contract and used the accrual method of accounting. Alternatively, the IRS stated that Basic Engineering must account for both contracts under the percentage of completion method "because [Basic Engineering] could not have estimated [its] completion within the two-year period beginning on the respective contract commencement dates."

Holding

Generally, taxpayers receiving income from long-term contracts must account for that income using the percentage of completion method of accounting, consistent with Section 460(a). This method essentially requires a taxpayer to recognize income and expenses throughout the duration of a contract. Two principal exceptions to this rule may, however, apply: Section 460(f)(2) excludes certain manufacturing contracts and Section 460(e)(1)(B) excludes certain construction contracts.

The Tax Court concluded that it did not need to determine whether manufacturing or construction was involved because neither exception applies; Section 460 requires the taxpayer to use the percentage of completion method of accounting for both contracts. The Tax Court found that the Petromaxx and Amber contracts are long-term contracts under Section 460 because they were for the "manufacture, building, installation, or construction of property" and the contracts were not completed within the tax year in which they were entered. The Court observed that the IRS's argument that the Petromaxx contract is a manufacturing contract and, therefore, Basic Engineering should have used the accrual method of accounting, is incorrect.

Specifically, the Court ruled that Basic Engineering did not satisfy the two-year rule exception for the completed contract method of accounting to apply in lieu of the percentage of completion method. Under the construction contract exception to the percentage of completion method, a taxpayer must estimate, when a contract is entered, that the contract will be completed within the two-year period beginning with the contract's commencement date. Considering the terms of the Petromaxx contract and expert witness testimony, the court ruled that Basic Engineering did not prove that it reasonably believed the contract would be completed within two years from the commencement date. Therefore, the Court held that Basic Engineering was not eligible to use the completed contract method of accounting.

Regarding the Amber contract, the Court found that, based on the terms of the contract, Basic Engineering had to deliver the last unit by November 15, 2010, which is more than two years after the commencement date. Like the Petromaxx contract, the Court found that Basic Engineering did not prove that it reasonably believed the contract would be completed within two years from the commencement date. Accordingly, Basic Engineering was not eligible to use the completed contract method of accounting.

The Court also upheld the IRS's accuracy-related penalties for 2009 and 2010.

Implications

This case underscores the importance of documenting the basis for the technical position associated with establishing a reasonable expectation as to the duration of the contract, as well as documenting facts relevant to establishing the fundamental nature of the contract (i.e., manufacturing or construction in this instance). The taxpayer did not meet its burden to prove that the IRS's determination regarding the project was arbitrary. That is, the Court concluded that the taxpayer did not establish that, at the time it entered into the contract, it reasonably expected the contract to be complete within two years of its commencement date.

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